Islamic bonds: then there was light

It’s no fun being a bond investor these days. You either invest in safe havens like US and German bonds and get a negative return, or go on adventure in countries like Spain and can’t be sure you’ll get your money back.

So the emergence of Shariah compliant sukuk offers an appealing middle way. With the London 2012 Sukuk Summit being held on June 6 and 7, beyondbrics reviews the latest developments in the market.

First to catch the eye is a steady rise in sukuk indices in the last few months. The Dow Jones Sukuk Index, for example, which measures the total return on US dollar denominated Islamic bonds, ended higher in May for the sixth time in as many months. Since 2009, the index has performed twice as well as the Barclays Capital Bond Composite Global Index, a benchmark for bonds.

The amount of sukuk outstanding is at an all-time high. In the first quarter of this year, $40bn was added to the pile, an increase of 48 per cent in new issuance compared with the same period last year.

Demand is strong for both corporate and sovereign sukuk, according to Tariq Al-Rifai, Dow Jones’ director of Islamic market indexes. A recent $4bn issuance by the Kingdom of Saudi Arabia was three times oversubscribed. A $1.75bn issue from the Saudi Electricity Company, the largest corporate sukuk of 2012, was ten times oversubscribed.

What explains this surge in popularity?

Since it was first re-introduced in Malaysia in the early 90s, the Shariah compliant bond type has enjoyed a steady rise in popularity in the Islamic world, both for issuers and for buyers. In the six years since its inception, the HSBC/Nasdaq Dubai US Dollar Sukuk Index has returned on average more than 5 per cent a year, notwithstanding the severe debt crisis in Dubai in 2009 which destroyed the value of many sukuks.

Until recently, the market was dominated by Malaysia. Now, a small sukuk renaissance is taking place in the Middle East. First banks and then companies in the Gulf region have started embracing sukuk issuance, explaining a large chunk of the increase in supply. Saudi Arabia is leading the way.

According to Nick Stadtmiller, head of fixed income research at the Emirates NBD bank, the roots for this remarkable sukuk awakening lie in the financial crisis in the developed world.

“About this time last year, a lot of Gulf-based issuers couldn’t get their traditional bonds sold because the markets in Europe were drying up,” he says.

This led some key institutions to rethink their attitude towards sukuk issuance. Before, the strict rules on sukuk made many of them conclude the game wasn’t worth the candle. Unlike bonds, sukuk have to be based on underlying assets, and they must be approved by Shariah scholars.

But the exceptional market circumstances made some issuers think again. Last year, conventional Arab banks like the First Gulf Bank and the Abu Dhabi Islamic Bank began issuing sukuk with success.

The same became true for some major Arab companies this year, such as Saudi Electricity ($1.75bn), the Saudi General Authority of Civil Aviation ($4bn) and recently the shopping mall operator Majid Al Futtaim ($400m).

The result is that sukuk supply is slowly catching up with demand, which had been increasing at the speed of sound in recent years – or better, at the speed of oil pumped out of Islamic soil.

For Stadtmiller, the fact that sukuk are now used as a replacement for a corporate loans means the market is at a “watershed moment”.

“I think we’ll see a lot more of these corporate sukuk in the future, many with a longer duration,” he says. (Sukuk can run for up to 10 years, whereas bank loans are often restricted to two or three years.)

There is no reason why the sukuk’s rise should stop at the borders of the Islamic world.

“There is also a strong appetite for sukuk among corporates in developed markets, such as GE Capital,” says Al-Rifai at Dow Jones. “If more western companies look to issue sukuk, they are bound to find a lot of interest from investors.”

That’s indeed very likely, as recent oversubscriptions suggest. Many wealthy investors in the Middle East can buy only sukuk as they want to comply with the Islamic ban on receiving interest. Western investors, from their side, don’t mind buying sukuk either. As sukuk are asset-based and many Islamic funds hold them to maturity, they are seen as a relatively safe investment.

But those looks can nevertheless be deceiving. Among all the optimism, you could almost forget that sukuk is a whole class of assets, not a homogenous product like US Treasuries.

Whether the issuers chose sukuk or regular bonds, their own creditworthiness is in the end what makes the difference. Investors who bought Dubai issued sukuk before 2009 will know what that means.

But in these uncertain times, sukuk remain highly valued among investors. With an average yield of 3.8 per cent, it is not hard to see why. Chances are the Sukuk Summit that started on Wednesday in London will only solidify that reputation.

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